We believe that the global economy will continue to grow; SHARE WATCH.
WITH equity investors now more visibly in thrall to the central bankers, the potential for a setback in equity markets, long expected, has certainly increased.
Last week, we cut our recommended tactical allocation to developed equities back to neutral to reflect this view. Calling shortterm moves in equity markets, up or down, is always hazardous. Many of the factors that tend to dominate short-term moves in company share prices are as impossible to forecast as where a roulette ball will settle. Alongside this, industry equity ownership and flow data can often give us the wrong signals about how widely the investment community have participated in rising or falling equity markets. Right now, the suspicion remains that there are many investors yet to participate in the latest multi-year rally in developed equity markets. This, along with an alarming consensus of talking heads predicting a setback in markets, but also another year of attractive relative returns next year, may indeed limit the scale of a market set back when and if it does materialise. Or it may not.
In the medium term, valuations and corporate profits growth tend to play a much larger role in equity market returns. These are areas where our predictive efforts are much more likely to rewarded, though plenty of humility obviously remains appropriate. We believe that the global economy will continue to grow at above stall speed, particularly as headwinds from austerity obsessed governments in the West recede, and private sector confidence continues to unevenly return. Remember that growth is the norm not the exception and it has been more profitable to invest around this assumption over the decades than the currently fading idea that depression and economic catastrophe lie constantly in wait.
Taking this into account, if one starts to look at companies based on a conservative estimation of the present value of all of their future cash flows - rather than just those we are expecting next year - current stock market levels still look like an attractive medium term entry point, even if a rise in equity market volatility from currently depressed levels is a given.
Theory suggests that a company's share price (and therefore that of the equity market) should encompass all of the future cash flows that this company will generate discounted back to a present value. Within this equation, there are three important moving parts: the expected growth this company or index will generate over its life, the level of profitability the company can sustain, and how to adjust those future cash flows to factor in their risk. First of all, what sort of earnings growth rate should we assume? Looking at earnings from the US stock market, the average over the last 50 years is close to 7% (geometric). However, for our purposes it is probably worth erring on the conservative side - 4% is the geometric average of the last five years. In terms of profitability, the 10-year rolling average return on equity is 14%, but to give ourselves some wriggle room, we move to a standard deviation below the rolling average trend, to 13%. Adjusting these forecast future cash flows in order to bring them back into the present day, we need to filter them through a discount factor that adequately compensates us for uncertainty of the time spent waiting for them.
By Andrew Miller, Barclays Wealth and Investment Management, Newcastle
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|Publication:||The Journal (Newcastle, England)|
|Date:||Dec 2, 2013|
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